Bitcoin value crashes below cost of production as broader use stutters

Hackers' virtual currency and favoured means of exchange drops from $33 high in August to below $2 as cost of 'mining' coins falls below real-world exchange rate
Bitcoin value has fallen since June 2011
The value of Bitcoins has dropped dramatically since June 2011 when they peaked at $33: now they are between $1 and $2. (Black line: closing price on MTGox Exchange. Red and green lines: volumes.)

The value of Bitcoins, the "cryptocurrency" that some had thought would take over from more traditional currencies, has plummeted across exchanges – to a level where it costs more to "mine" them than they are worth.

Though there's no obvious reason why, part of the problem seems to be precisely what economists remarked on when its value began to spike as more and more people piled in: the appreciation in value was a speculative bubble, caused by people hoarding the currency, rather than the start of a new (or parallel) economy.

The value of Bitcoins on one of its main exchanges, MTGox, has collapsed since mid-June from a high where it was trading at the equivalent of about $30 per "coin" almost to parity now. That still marks an improvement over the year: on 1 January 2011, Bitcoins traded at 30c each.

Bitcoins have risen in value since January 2011 Bitcoins have appreciated in value since January 2011, but fallen a very long way from their peak. (Black line: closing price. Red and green spikes indicate volume of sales.)

Similar falls in value are evident across other exchanges, as shown by the values on Bitcoin Watch, where the value of Bitcoins being traded has fallen from a high of more than $30 to between $1 and $2 now.

Bitcoins, which are in fact just very long strings of numbers, are "produced" by a processor-intensive calculation which requires increasing amounts of computing power to create each one. There is also a limit on how many can ultimately be produced, according to the algorithm which generates them. So far 7.48m have been produced.

The problem with the Bitcoins' value falling below the cost of "mining" – actually the computer time that has to be devoted to them – arises because as each "coin" (or computer hash) is generated, the peer-to-peer network used by computers that accept and generate them makes it harder to generate the next.

According to the explanation at Tradehill, "New coins are generated by a network node each time it finds the solution to a certain mathematical problem (ie creates a new block), which is difficult to perform and can demonstrate a proof of work. The reward for solving a block is automatically adjusted so that in the first four years of the Bitcoin network, 10.5m BTC will be created. The amount is halved each four years, so it will be 5.25 over years four to eight, 2.625m over years eight to 12, and so on. Thus the total number of coins will approach 21m BTC over time."

In May one user suggested that the effort being thrown at Bitcoins was wasted: "We're all trying to profit from the high exchange rates (1BTC is 9USD at the time of writing this) that we're throwing everything we've got at the bitcoin network. We profit from our actions for a couple of days, then the network detects the increase in speed and adjusts itself down, negating all the efforts we put into it, forcing us to buy even more processing power. It's an endless cycle of stupidity that simply cannot be solved by human nature."

With the value of Bitcoins dropping so low, and the computing power required to produce them growing steadily, it is becoming uneconomic to generate more except through the use of hacked computers in "botnets". Although there has been anecdotal evidence of their being used to generate Bitcoins, many botnets are hired out on a commercial basis to send spam or host phishing websites – and that may be more profitable, directly, than creating the currency.

Hackers and members of the underground like Bitcoins because transactions involving them are almost untraceable, yet can be carried out between computers. That has proved both a blessing and a curse, though, after one user discovered in June that his computer had been hacked and 25,000 Bitcoins – then worth almost $500,000 – had been removed from the "wallet.dat" file on his machine. Because of their untraceability, he could not know who had taken ownership of them.

A few days later MTGox itself was attacked when someone tried to sell more than 400,000 Bitcoins, which would have been worth about $9m. But that prompted a huge drop in per-coin value from more than $17 to $0.01 because there weren't enough buyers at the higher price. MTGox went offline and pledged to reverse the transactions.

However, commentators had suggested that the biggest weakness about Bitcoin was that although many were being produced, their apparent value was based on small numbers of transactions within a small group – which is not an effective model for a viable currency. Although there are a number of websites that accept Bitcoins in exchange for real-world goods and services, it is very difficult to measure how many transactions have occurred.

That, in turn, makes it hard to calculate how many people are using them. But graphs on a Belgian site that tracks the computational power being applied to Bitcoin mining suggest that the amount dedicated to it peaked in mid-August, and has fallen since then. That would indicate that fewer people are trying to mine Bitcoins – even though only one-third of those that could be discovered have been.

Paul Krugman, a Nobel prizewinner in economics, criticised Bitcoin in an article in the New York Times in September:

"What we want from a monetary system isn't to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that's not at all what is happening in Bitcoin. Bear in mind that dollar prices have been relatively stable over the past few years – yes, some deflation in 2008-2009, then some inflation as commodity prices rebounded – but overall consumer prices are only slightly higher than they were three years ago. What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation."

Writing in the September/October edition of Technology Review, the New Yorker financial writer James Surowiecki noted that Bitcoin might indeed be trapped in a deflationary spiral:

"With ordinary currencies, though, there's a limit to how far down the spiral can go, since people still need to eat, pay their bills, and so on, and to do so they need to use their currency. But these things aren't true of bitcoins: you can get along perfectly well without ever spending them, so there's no imperative for people to stop hoarding and start spending. It's easy to imagine a scenario in which the vast majority of bitcoins are held by people hoping to sell them to other people."


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